Tuesday, April 15, 2014

DC Circuit Strikes Down Conflicts Minerals Reporting

The U.S. Court of Appeals for the District of Colombia, which hears many issues involving administrative law and government action, has overturned part of the SEC rule requiring companies to report on their web sites that their products are not free of certain minerals from the Democratic Republic of Congo and surrounding countries. The case is National Association of Manufacturers v. Securities and Exchange Commission.

Before we get to the legal issues, the background provided by the Court is relevant to what is at issue. The Democratic Republic of Congo ("DRC") is an unimaginably hellish place. It has seen 15 years of war and starvation coupled with widespread human rights violations including the use of rape as a weapon. Much of that activity is undertaken by armed militias financed by the sale of gold, tantalum, tin, and tungsten extracted by primitive, unregulated mining operations in Congo. After passing through many hands, these minerals end up in products sold to consumers in the U.S. including mobile phones, golf clubs, medical devices, and automotive parts.

As a response to this situation, part of the Dodd-Frank Wall Street Reform and Consumer Protection Act required publicly traded companies regulated by the SEC who are using conflict minerals in products to investigate and disclose whether those minerals originated in DRC or an adjoining country. The report must include a description of the diligence undertaken to identify the minerals and their source. The companies must also list products that are not free of conflict minerals. There is no de minimis level under which the report is not necessary.

Many companies rolled this requirement into their compliance procedures. For example, Intel has open sourced its compliance process in an effort to help other companies comply and, therefore, reduce the trade in conflict minerals. But, this is not without costs. According to SEC estimates, the rule would cost industry $3 billion to $4 billion initially and between $207 million and $609 million annually thereafter.

Now on to the law.

The Administrative Procedure Act prohibits agency action that is arbitrary, capricious, an abuse of discretion, or otherwise not in accordance with law. When reviewing an agency action, the Court considers only the administrative record.

The first argument against the regulation was that the SEC failed to include a de minimis exception for small amounts of conflict minerals. According to the National Association of Manufacturers ("NAM"), plaintiff in this case, that was an abuse of discretion. The SEC acknowledged that it could have created a de minimis exception. However, it considered that possibility and found it to be inconsistent with the Congressional purpose for the law and also the fact that very small amounts of the minerals may nevertheless be important parts of the finished goods. Given that agency consideration, the Court found no abuse of discretion.

Next, NAM argued that the SEC requirement to perform due diligence and report findings is inconsistent with the requirement to report the presence of conflict minerals in products. The Court also rejected that argument. It is true that the statute requires reporting only when conflict minerals are found to be present. The regulation requiring an inquiry is not intended to implement that reporting requirement. Rather, it requires companies to examine their supply chains to determine whether the reporting requirement applies. The Court found this to be a reasonable exercise of rulemaking in the absence of clear statutory language to the contrary. Similarly, the SEC acted properly when it applied the due diligence and reporting requirements to both manufacturers and to companies that contract for the manufacture of goods.

A more interesting problem for the regulation is whether it produces the benefit Congress intended, which is to burden the illicit mining industry in DRC and try and choke off resources from the armed groups participating in the conflict. According to the Court, "[W]e find it difficult to see what the Commission could have done better." The fact that the SEC could not quantify those social benefits does not invalidate the rule. The Court went on to say that it would not require the SEC to "measure the immeasurable" through a detailed quantitative analysis. "Even if one could estimate how many lives are saved or rapes prevented as a direct result of the final rule, doing so would be pointless because the costs of the rule--measured in dollars--would create an apples-to-bricks comparison." Given the congressional mandate to enact regulations addressing conflict minerals, the SEC's rulemaking was appropriate.

Then there is the constitution. The thing about constitutional cases is that the result often turns on figuring out the correct standard the court is to apply to review the governmental action. Here, NAM argued that forcing companies to state that their products are not free of conflict minerals violates the companies' first amendment rights by compelling commercial speech. Some first amendment issues are reviewed on the "rational basis" test under which the regulation will be upheld if it is reasonably related to a governmental interest. This has usually been applied where the compelled disclosure is limited to simple facts to avoid consumer deception.

But, the conflict minerals regulations do not involve simple facts or consumer deception. Rather labeling a product as "conflict free" implies a certain moral standing and can be read as including a moral indictment of companies producing products that are not conflict free. According to the Court, the regulation "requires an issuer to tell consumers that its products are ethically tainted, even if they only indirectly financed armed groups." More directly, the Court stated that by "compelling an issuer to confess blood on its hands, the statute interferes with that exercise of the free of speech under the First Amendment."

Consequently, the Court analyzed the regulation under the so-called Central Hudson test. Under this test, the regulation is permitted if the SEC can show (1) a substantial government interest that is  (2) directly and materially advanced by the regulation and (3) that the restriction is narrowly tailored. It is the last point that proved to be a problem for the SEC. According to NAM, the purposes of the statute and regulations could have been advanced while letting the regulated companies decide how to convey the message or by having the government compile and maintain a list of non-conflict free products. According to the Court, the hypothetical centralized list might prove to be a more efficient means of communicating this information to the public. Thus, the Court found that the restriction imposed by the conflicts minerals reporting requirement was not narrowly tailored to the extent that the  rule requires regulated companies to state that their products have "not been found to be 'DRC conflict free.'"

Two important side notes:

First, in a partially concurring opinion, one of the judges noted that a similar question is currently pending en banc review by the entire Court of Appeals (rather than just a three judge panel). That case involves the compelled use of country of origin labels on meat products. The issue there is whether the more relaxed rational basis test applies to origin labels. The decision in that case, American Meat Institute v. United States, may impact the analysis in this case. Thus, the judge would have waited for that decision before deciding this case.

Second, in discussing the possibility of staying the judgment in this case pending the decision in the meat labeling case, the concurring judge stated "It bears noting that there would be no evident need to stay any part of the statute as opposed to the SEC's rule." That is because the statute, unlike the regulation, does not mandate the format of the not conflict free notice. This gives the regulated companies more options and, arguably, resolves the First Amendment issue. Thus, it appears that the law, but not the implementing rule, may continue in force.

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